The purpose of surety bonds is twofold. First, to encourage an obligee to enter into a contract with the principal. A party will be more likely to enter in a contract if they have some assurance that the principal will perform their part of the bargain. A principal who is backed by surety is generally held to be more trustworthy.
Second, a surety bond serves to encourage the principal to obey the contract. A principal is also more likely to perform their duties if they know that a third party has vouched for their credibility.
Surety bonds are commonly used in connection with:
- Mortgages (“Mortgage Broker Bonds”)
- Notary Bonds
- Auto Dealer Bonds- this is the most common form of surety bond
- Construction contractor’s bonds (these are also very common and contain several subcategories, such as performance and payment bonds, bid bonds, and maintenance bonds)
- Court bonds arising out of litigation
Thus, surety bonds may be used to secure performance in any situation where one party owes a debt or contract duties to another.
If the principal fails to fulfill their contract duties, what happens is that the obligee will then recover their losses using the funds provided by the surety. They will usually be able to recover lost profits, but in some jurisdictions, recovery is limited to the bond amount. The obligee is usually required to pay yearly premiums in order to have the funds available in the event of a breach.
The surety will then turn to the principal in order to be repaid for their financial backing. The surety can also recover other costs from the principal such as litigation fees and court costs, if necessary.
Sometimes it happens that the obligee fails to render payment to the surety. If this occurs, a lawsuit may follow compelling the obligee to render payments to the surety. If the principal is still unable to render payments, a lien may be placed on their property in order to recover the payments.
Whether you are the obligee, principal, or surety in a contract, it is important that you consider working closely with a lawyer during negotiations. A financial lawyers can help make sure that you understand the requirements and duties of the various parties. Your lawyer can help you draft and review the surety agreement in a manner that meets the needs of each party. Also, in the event of a lawsuit, your lawyer can advise you on how to recover your losses.